ECONOMICS U$A
Episode 8

THE BANKING SYSTEM
PURPOSE:
To help viewers understand the key role of banks in the U.S. economy and how government agencies act to prevent individual bank failures from becoming banking crises.

OBJECTIVES:
1. Banks play a key role in the economy by holding deposits, handling withdrawals, and making loans.
a) banks only need a small fraction of their deposits in cash to handle withdrawals.
b) banks are forced by banking regulations to hold a certain percentage of their deposits as reserves.

2. A balance sheet tallies a bank’s assets and liabilities.
a) cash and loans are the primary assets
b) deposits are the primary liabilities

3. The banking system can expand the amount of money in circulation by making loans.
a) the amount of the expansion is limited by the reserve ratio.
b) during depressions deposit contraction takes place.

4. Various government agencies regulate banks and are able to reduce the risk of bank failure.
a) the Federal Reserve acts as a lender of last resort.
b) the FDIC insures the deposits of some banks
c) regulators examine banks’ books in order to prevent excessively risky
bank practices

KEY ECONOMIC CONCEPTS:
deposits, multiple expansion of bank deposits, reserve ratio, lender of last resort, liabilities, loans, balance sheets , assets, Federal Reserve System, bank runs, FDIC, deposit insurance, fractional reserves, deposit contraction

Contemporary Issues
The Banking System

During the course of 2001, the Bank of Japan increased bank reserves by 25%. During that time, bank lending fell by 2%. What might explain the apparent divergence between the increasing reserves in a bank and its unwillingness to make loans? How much of this might be due to a lack of demand for new loans (because of weak economic growth) or risk aversion on the part of the banks (because they already have a large portfolio of loans in default)? How might the Bank of Japan go about fixing this problem?

For a complete transcript of this video program download TVpdf#8

Knickerbocker Trust
It was money from the banks of New York in 1907 that kept New York moving and growing. People trusted their saving in banks like the Knickerbocker Trust. Like most banks, the Knickerbocker held only a fraction of its depositors’ money in reserve and loaned out the rest. Banks at that time had a strong entrepreneurial drive while at the same time there was inadequate government surpervision.
Charles Barney, president of the Knickerbocker, became involved in a scheme to manipulate the price of copper on Wall Street. It went bad and when depositors learned that the bank was in trouble they started to take their money out.Barney went to JP Morgan to temporarily borrow the cash the bank needed. Morgan turned him down. Depositors panicked. The panic spread to 246 other banks which closed. It wasn’t until JP Morgan finally agreed to put up the money, that the panic stopped. Too late to save Barney, the Knickerbocker and others.Bankers realized that they couldn’t necessarily rely on JP Morgan or any individual. The bankers turned to the federal government and accepted the need for a central bank. However, they wanted to keep a fractional reserve banking system.

Comment and Analysis by Richard Gill
The reason why bankers wouldn’t want to give up a fractional reserve system is because they make money by lending out their depositors. Gill explains how a bank can get into trouble if people believe it is in trouble. Everyone wants their cash on demand, but as the case of the Knickerbocker illustrates, the bank is not going to be able to satisfy them if they all want it at the same time. Usually the system works if people believe their money is safe.
The Federal Reserve
The Federal Reserve was intended as a lender of last resort, loaning money to banks such as the Knickerbocher Trust which were basically sound but temporarily needed help. The Federal Reserve supported the boom of the 1920’s by increasing the money in circulation. It did this by making loans. However, banks started becoming too liberal in its loans and credit stands. Banks gave liberal loans to investors. Investors in turn speculated widely on the stock market. Wall Street boomed until Black Thursday, Oct 24, 1929 when the market fell, pushing the country into the Great Depression.
It wasn’t until thousands of banks failed in the early 1930’s and Roosevelt elected that strong banking safeguards were enacted. One of Roosevelt’s first presidential acts was to declare a National Bank Holiday so individual banks could be reviewed and enable only banks that were declared safe to be opened. Also he passed legislation that extended the powers of the Federal Reserve, forcing banks to meet tougher regulatory standards and created the Federal Deposit Insurance Corporation to guarantee each customers account up to $10,000. This helped American regain their faith in the re-opened bank and the crisis passes. The bank holiday was a watershed in the Depression.

Comment and Analysis by Richard Gill
With a look at banks balance sheets, Gill shows that banks can actually create money. It can cause a multiple expansion or contraction of money throughout the economy. The banking system creates money by making loans. As a loan was granted, credit was created and more money flowed through the banks. It had a multiplying effect. Workers earned their wages and wages went into a bank, where it could be loaned out to other people to buy items and more money flowed through banks. Business owners could then make more investments so more money would flow through the banks.
Banking Regulation
The Federal laws for over 50 years kept banks and Saving and Loans (S&Ls) out of high risk ventures. Then in the seventies and eighties, the government gave S&Ls the green light to offer higher interest and get into high-payoff real estate deals. High rolling S&L execs gambled on real estate and lost big. Taxpayers ended up with the bill, almost a half-trillion dollars. Commercial banks lost money on loans to third world countries and on high risk junk bond offerings.
There was debate among politicians on how much freedom and deregulation should be given to the banks. President Bush and Congressman John Dingell Jr., chairman of the House Energy and Commerce Committee had opposing views. Dingell believed that the banks needed to be strictly regulated. Bush believed that the banking industry knows better how to regulate itself and that market forces are the best judge, not the government, as to what things should be offered to the customers. President George Bush sent Congress a bill that would allow banks to provide a variety of financial services. The President’s bill lost, and the legislative walls that restricted banks to banking still stood.

Comment and Analysis by Richard Gill
Economist view banking regulation with ambivalence. It has been argued that it was deregulation and lack of adequate supervision that threw the S&Ls and later the commercial banks into disarray. Or, it can be and has been argued that the real problem has been government intervention—raising the level of deposit insurance to $100,000 and thus encouraging high-risk loans and investments. The real issue is how to protect depositors without giving the green light to the reckless and imprudent, not whether to protect the system, but how?